Michelle Russell-Dowe, a director at Hyperion Capital Management in New York, is the portfolio manager responsible for all asset-backed and non-agency subordinate investments.
BW: Tell us a little about your ABS portfolio.
MRD: We have $1.4 billion in ABS under management, for our clients in both dedicated mandates and as part of an overall MBS or aggregate strategy. In capitalizing on our firm's credit orientation, we most often participate in the subordinated classes of ABS structures. In ABS, our current allocation is overweight to HEL and NIM securities, while we are underweight and reducing holdings in auto and credit cards--particularly those single-A and higher. We have very limited exposure to ABS backed by manufactured housing, aircraft, equipment leases and franchise loans.
BW: With that in mind, what sectors are you favoring now and why?
MRD: Over the past six months we have been increasing exposure to HELs, both fixed and floating, seasoned and new issue. Our emphasis has been in the single-A, single-A minus, triple-B plus and triple-B classes, but some seasoned premium triple-A securities are also attractive. We have chosen to focus on areas that offer wider yield spreads primarily due to technical factors. Additionally, to some extent we have taken advantage of the higher yield spreads available on triple-B minus rated floaters.
I would add a caveat here: As opposed to a straightforward sector overweight, or a beta approach, we employ an alpha-oriented approach. We think there are particular issuers, transactions and classes that offer superior relative value within a sector. For instance, while we believe that the HEL sector generally offers attractive value now, we also believe that there are certain regulatory or issuer-specific risks, as well as structural differences in transactions, that merit consideration.
As an example, we would exploit the current tiering in the HEL market--certain issuers' bonds trade at yields well tighter or wider than other issuers. Our approach involves research, an understanding of a business model and an information flow that results in a specific opinion on an issuer within a sector. We look to capitalize on issuers we hold a higher opinion of than do the rating agencies or the overall market. We look for upside this way within each sector of the ABS market, and we would stress the importance of that approach. With the variation in the market and the current regulatory environment, sometimes identifying good versus bad securities is like trying to find Joe Millionaire rather than the guy making $60 a week.
In addition to triple-B credit cards--which we look to add--we believe that there are opportunities in certain distressed sectors, such as MH. With a bevy of performance information, at a price that is discounted sufficiently, some MH securities offer an acceptable upside/downside profile. On the other hand, with franchise or pooled aircraft ABS, we find either the information or the upside potential to be lacking.
BW: Which are the top issuers in each of the major asset classes?
MRD: Given Hyperion's style, we would look for the best opportunity, which is an issuer for whom we think there is the best risk/reward. In this context "top issuer" really translates to "top opportunity." For example, in HELs, Option One is one of the largest issuers, while Chase Funding has the tightest yield spreads. We have participated in both names, but currently would rank neither one as the top opportunity. Instead, we would be looking for the issuer whose securities offered the best combination of return/yield spread and were best protected by credit enhancement. In HELs, I believe Long Beach may represent an undervalued prospect. By the same token, a few months ago, MBNA was our top choice at the triple-B level in credit cards. But, at current levels, we would revise that recommendation and look at triple-B cards from the bank issuers. Within autos, we are avoiding sub-prime and near-prime unwrapped auto paper. Among prime issuers, we recommend selling triple-A issues at current spreads.
Similarly, in the other sectors, the more distressed an asset class becomes, the more the concept of "top issuer" is void and the more security-specific our recommendation becomes. As such, I would not list Vanderbilt as the MH sector's top issuer in our framework, even though they may be the only lender to survive intact.
BW: Investors are paying more attention than ever to the servicers and trustees of asset-backed deals. How do these considerations affect your overall investment decisions?
MRD: We are very involved in security- and issuer-specific analysis, and servicer evaluation has always been a part of that. Early on in my career, on a servicing review someone told me it is very easy through servicing to "to make a good loan bad, and very difficult to make a bad loan good." I believe that is true and underscores the importance in the origination of a loan. But what is not clearly enough stated is that servicing and keeping good loans good is absolutely crucial to a transaction's performance.
We limit our investments by credit rating to those deals serviced by a counterparty that we feel we understand, and one that has a track record we can evaluate.
We embrace the notion that there are some unacceptable counterparties--at any price. This is particularly true because in fixed income, your upside is your coupon, while your downside is a total loss of principal.
What has made this environment even more interesting is the regulatory wildcard, which can at any moment change the lending and servicing rules, or even the securitization rules. This keeps us constantly aware that the ABS market is not a commodity market, that asset selection is critical and surveillance is even more critical.
In the current environment, we feel that approaching the market through very specific information and opinions on a security-by-security basis is just prudent business practice. We have seen transactions come to market and be instantly oversubscribed, but we are comfortable letting bonds trade away to the extent we don't have sufficient time to complete our analysis.
BW: Home equity has seen a ton of growth this year and is the largest asset class, far and away. Do you see this trend continuing? Is there any technical overhang or is there enough investor appetite?
MRD: I don't see home equity issuance keeping up the same pace indefinitely for two reasons. First, in the sub-prime market, home price growth has a lot to do with the borrower's ability and incentive to refinance their loans. And, I do believe there will be a future moderation in home price growth that will put an upper limit on volume. Second, I believe that interest rates, including home equity mortgage rates, will rise. As an aside, unlike the 1998-1999 rally where sub-prime mortgage rates did not fall nearly as much as prime mortgage rates, sub-prime mortgage rates have fallen substantially since 2000. I believe that at current levels, issuance is already a substantial technical factor. It is one of the reasons I believe the HEL sector is attractive.
BW: At what point does the amount of issuance become a concern on the credit side? Are lenders being too aggressive?
MRD: In the past, it has been the lower volume/higher interest rate environment that has caused a stretch for volume and a clearer compromise of credit quality by lenders.
Currently, credit quality appears to be more consistent. This should be considered in light of another factor: if volume is high and issuers can attract a similar borrower--then why should tiering be so prominent? We believe there are two answers. The first is the impact of the servicer and perception of safety. The second is that looking at average characteristics is a problem--particularly for subordinate buyers.
The risky tail of the distribution should be considered. These tails can provide evidence of both credit standards and quality control. Also, it is basic prudence to recognize that with low LIBOR financing, it is attractive to lend currently. But, should LIBOR rise, current performance could be called into question as the borrower's mortgage rate will reset higher, in some cases much higher, than their current fixed rate.
In some cases, I think an argument can be made that too much credit has been given to a weaker borrower segment. There is a rate below which investors should be unwilling to lend. To some extent, this may also be a factor that has contributed to wider yield spreads. And in certain sectors, past times of crisis have been preceded by periods of very low yields and yield spreads, meaning investors are providing financing too cheaply. And, that doesn't provide incentive for the best lending behavior.